The Dollar is Up? The Dollar is Down?

What does this all mean? You hear it regularly in the news: “The dollar rose today against other major currencies,” or “The dollar lost ground today on foreign exchange markets.” Just like stocks or bonds, currency’s value can fluctuate in comparison to each other on a daily basis.

For example, at the start of 2011, it would have cost approximately $1.34 to purchase one euro (the European common currency). By the end of April, the U.S. dollar lost value, and $1.48 was required to buy a single euro.

Why should you care? Because currency fluctuations affect anyone who buys goods made in other countries, travels abroad or invests globally. In other words, almost all of us are impacted on some level.

The impact of fluctuating currency values

Consider what happens if you are traveling overseas. If the dollar loses value compared to the currency of the country you’re visiting, it will cost more to make purchases in that region. If the dollar strengthens, your buying power will improve.

In terms of the larger economy, U.S. companies seeking to sell products overseas will benefit when the dollar is weaker because this makes it cheaper for other countries to purchase American-made goods. In general, multi-national companies that sell American goods around the world will generate more profits from sales during periods of a weak dollar.

As an investor in overseas stocks, you also may benefit when the dollar is declining in value. Suppose you invest $1,000 in a European company at a time when the exchange rate is $1.25 U.S. per euro. Your investment would be worth 800 euros. If after one year, the investment appreciates by five percent, it will be worth 840 euros. But if at the same time, the U.S. dollar had weakened to $1.35 per euro, your investment would be equivalent to $1,134, representing a much more sizable gain of 11 percent. The bulk of the return, in this case, comes from the euro gaining strength. By contrast, if the dollar gained ground during that period, your investment, when sold, would be worth less after being converted back into U.S. currency.

An unpredictable market

One of the significant challenges of the currency market is that it is very unpredictable in the short run. Any number of factors can come into play in determining the strength of a specific currency. A currency tends to become more valuable when the demand for it exceeds available supply. A number of factors can affect the exchange rate. For example, the dollar may be more attractive to others if interest rates here are higher and bond investors can gain a yield advantage by putting their money in bonds from U.S. issuers. Currencies may also thrive if a nation’s economy is strong (relative to other world markets) and business activity is high.

But movements in currency values can also be affected by the actions of speculators who may try to take actions that affect the short-term direction of the exchange rate.

Overall, it is important to understand that the changing value of the dollar is a factor to consider when investing in global companies or purchasing foreign products, though the risk associated may not be largely influential.